Will The Rising Cost Of Cheese Bring Down Domino's, Papa John's, and Pizza Hut?

Foolish investors may not be aware of the fact that the price of mozzarella cheese, a key ingredient in pizza, has been skyrocketing recently. In fact, it has risen by 15% over the last two years. Back in January 2012, the wholesale price of mozzarella was $2.44 a pound; this January, the price had risen to $2.81 a pound. Given that cheese is perhaps THE key ingredient in pizza, what are the ramifications for major pizza chains given that their key ingredient keeps rising in price?

Source: Understanding Dairy Markets

Several reasons contributed to this dramatic rise in prices. Dairy exporters from Europe and New Zealand were hit with adverse weather conditions in 2013 which limited their dairy production. Because of this, U.S. cheese exports in the first 10 months of 2013 were up 17% over the previous year. China, in particular, is soaking up more of our exported dairy products, causing the cost of cheese to rise. Domestic U.S. consumption of cheese also grew by 2% this year.

With cheese on just about every pizza pie, what does this mean for pizza makers like Domino's (NYSE: DPZ) , Papa John's (NASDAQ: PZZA) ,and Yum! Brands' (NYSE: YUM) Pizza Hut? Will they pass on their costs to consumers? Would more costly pizza cut into their revenues?

How much of a cheesy bite isit?Cheese is the most costly ingredient for pizza makers. For example, cheese makes up between 35-40% of Papa John's food costs. However, Papa John's, Domino's, and Pizza Hut can handle the growing cheese prices, as they have systems that can hedge price changes or offset the costs by reducing costs of other ingredients. For instance, a record wheat harvest last year dropped the cost of the dough for Domino's, which should help ameliorate the rising cheese price.

Bloomberg Businessweek reported that at a January 2014 investor's event, Domino's Chief Financial Officer Michael Lawton wasn't too concerned about the rising cost of cheese impacting retail pizza prices. "In the last couple of days, I've had a lot of questions about cheese because it spiked up, and cheese is the biggest commodity," Lawton said. "Even taking that into account when you look at the whole basket, and you look at the projections on cheese for the year, we are still projecting that we would be down in the range of 0 percent to 2 percent."

Furthermore, pizzerias have fewer food costs than other successful restaurants. Pizzerias' food costs come in at around 20% of their sales, while other types of restaurants' food costs come in at around 27-32% of their sales. Even if cheese prices get too high, pizza makers can look to cut costs in other areas while not compromising on the quality of their food.

While there may not be a jump in the retail cost of a pizza pie from Papa John's, Domino's or Pizza Hut, the growing cost of cheese will be felt in other ways. For example, franchisees, who buy their ingredients from their chain companies, will offer fewer pizza promotions and discounts to offset the rising cheese costs. Alternatively, the three large pizza makers can also promote non-cheese menu items, including chicken wings or breadsticks.

Who might melt away?The pizza makers who are most at risk due to the rising cost of cheese are the independent or local pizza stores. The smaller pizza stores have tight margins on each pizza pie, so they make less as the prices of ingredients cost more. However, the smaller restaurants are reluctant to raise prices, given the competition from the larger pizza makers. Unlike Papa John's, Domino's or Pizza Hut, the smaller stores aren't as able to hedge or offset the rising cheese prices nor are they able to compete with more extensive non-cheese menus. Also hurting the smaller pizza makers is the fact that most do not have digital, mobile, or television exposure to help them market, unlike their larger competitors.

Do investors say cheese?So what do higher cheese prices mean for Papa John's, Domino's, and Pizza Hut and their investors? Probably not too much, even though cheese is their most costly ingredient. First off, food costs make up a smaller percentage of expenses for most pizza makers than they do for other restaurants. The large pizza makers already have systems in place to hedge or offset the rise in cheese prices. All three carry arrays of non-cheese menu items. All three have digital, mobile, and television marketing platforms to help keep their products in the minds of consumers. The rise in cheese prices may be beneficial for them -- by eliminating competition from smaller pizzerias that struggle to keep up with price increases. Many investors feel equally confident in these companies as all three of them have P/E ratios over 30, above the industry average of 22.70.

So Foolish investors, grab a slice of one of the large pizza makers -- they won't be stuck to the ground due to the price of cheese.

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